In its joint proposed rule and guidance on product definitions with the SEC, the CFTC has provided guidance on the exclusion of forward contracts (with respect to nonfinancial commodities) from the definition of the term “swap,” which finds its statutory authority in the Dodd-Frank Act’s exclusion of “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.”
1. The CFTC will interpret the forward contract exclusion from the term “swap” consistent with its historical interpretation of the forward contract exclusion from the regulation of futures contracts.
2. Intent to deliver is an essential element of a forward contract excluded from both the swap and futures contract definitions, and such intent in both instances should be evaluated based on the Commission’s established “facts and circumstances” test.
3. Book-out transactions in nonfinancial commodities that meet the requirements specified in the Brent Interpretation* (i.e., underlying contracts that (i) create a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis and (ii) are between market participants that regularly make or take delivery of the referenced commodity in their ordinary course of business) and for which any book-out, offset, cancellation, or settlement on a payment-of-differences basis is effectuated through a subsequent, separately-negotiated agreement, should qualify for the forward exclusion from the swap definition.
Commodity Options Embedded in Forward Contracts
Given that commodity options are explicitly included in the Dodd-Frank Act’s definition of the term “swap” but forward contracts are explicitly excluded, the CFTC provided guidance regarding the treatment of embedded commodity options in forward contracts. Continuing to follow its 1985 Interpretation,** the Commission stated that a forward contract that contains an embedded commodity option would be an excluded forward contract (i.e., not a swap) if the embedded option:
1. May be used to adjust the forward contract price, but does not undermine the overall nature of the contract as a forward contract;
2. Does not target the delivery term, so that the predominant feature of the contract is actual delivery; and
3. Cannot be severed and marketed separately from the overall forward contract in which it is embedded.
Comments on the proposed interpretation are due 60 days after it is published in the Federal Register. The Commission has requested comments on the following (and other) aspects of the proposed interpretation:
27. Should a minimum contract size for a transaction in a nonfinancial commodity (e.g., a tanker full of Brent Oil) be required for the transaction to qualify as a forward contract under the Brent Interpretation?
28. How often, and to what extent, do entities that do not regularly make or take delivery of the commodity in the ordinary course of their business engage in transactions that should qualify as forward contracts? Should such contracts qualify for the safe harbor provided by the Brent Interpretation?
30. Should contracts in nonfinancial commodities that may qualify as forward contracts be permitted to trade on registered trading platforms such as DCMs or swap execution facilities (“SEFs”)?
32. Should the forward contract exclusion from the swap definition apply to environmental commodities such as emissions allowances, carbon offsets/credits, or renewable energy certificates?
35. How would the proposed interpretive guidance set forth in this section affect full requirements contracts, capacity contracts, reserve sharing agreements, tolling agreements, energy management agreements, and ancillary services?
* Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39,188 (1990) (“Brent Interpretation”).
** Characteristics Distinguishing Cash and Forward Contracts and “Trade” Options, 50 Fed. Reg. 39,656 (1985) (“1985 Interpretation”).